What’s the Fed’s ‘Neutral’ Interest Rate? Why Does It Matter?

Central banks seek to manage economies by setting interest rates at levels that encourage or discourage activities such as car purchases and construction projects. These efforts revolve around a number that’s right in the middle — the rate that does nothing at all, also known as the neutral interest rate. It’s an important guidepost right now because monetary policymakers across advanced economies are cutting rates as the inflationary years of the pandemic period draw to a close, but they’re doing it with some caution as new inflation risks simultaneously emerge. That means the debate over the neutral rate will influence how long central banks will keep cutting interest rates.

In theory, the neutral interest rate — or, as it’s usually recorded in economic models, r*, pronounced “r-star” — is the rate at which monetary policy is neither stimulating nor restricting economic growth. As former US Federal Reserve Vice Chair Lael Brainard put it in a 2018 speech, it’s the level that “keeps output growing around its potential rate in an environment of full employment and stable inflation.” (The benchmark the Fed uses to direct monetary policy is known as the federal funds rate.)